Airline stocks don’t seem to be favorably viewed by investors even as they have various factors going for them. One reason they have taken a recent hit is that the Department of Justice is investigating whether some major airlines colluded in order to reduce available seats and keep airfares higher. This has negatively impacted the stock of companies such as American Airlines Group, Inc. (AAL) and Delta Air Lines, Inc. (DAL) (See related: DOJ Investigating Collusion Among U.S. Airlines)
In spite of this, investors with a long-term orientation should have airline stocks on their radar, taking into account various reasons that bode well for these stocks. In fact, Wall Street analysts expect airline stocks to see considerably higher earnings effect in 2015, largely because of oil prices.
Impact of Lower Fuel Prices
Oil prices started taking a deep dive in 2014 and then slowly started recovering earlier in 2015. After mid-year, they have started their downward descent again. The U.S. Energy Information Administration is anticipating lower oil prices for 2015. This comes about as the Chinese economy, a major commodities consumer, is slowing reducing demand for oil. At the same time, the Organization of Petroleum Exporting Countries (OPEC) has boosted its output, thereby driving up supply of oil. And fracking activity in the United States has also contributed to rising supply in recent years.
Considering that fuel prices are a major expense for airlines, constituting their biggest operating expense, this decline in oil prices bodes well for airline stock. Delta alone expects to save more than $2 billion on fuel costs for 2015, while Southwest Airlines Co. (LUV) expects to chop at least $1.7 billion off its fuel costs for 2015.
Airlines have had to hedge for higher oil prices, much like taking out an insurance policy, so that they don’t have to take a cut to their profits as oil prices rise. Earlier this year, companies such as Southwest Airlines and United Continental Holdings, Inc. (UAL) saw their profits decline as their contracts to hedge for higher oil prices lost value as oil prices declined. One case for not hedging is that oil prices tend to go up in a rising economy, which also causes airfares to go up. That’s why companies such as American Airlines don’t tend to hedge for oil prices. If other airlines feel more optimistic about lower oil prices, they could also cut down on their hedging activity and save money after their current hedging-related contracts expire.
Another factor favoring airline stocks is that there has been major merger activity in recent years, such as the 2013 merger between American Airlines and US Airways, which has reduced the number of airline companies and cut down on competition. Other major mergers in the airline space include that of Delta and Northwest Airlines Corp. in 2008, and that of United Airlines, Inc., Continental Airlines, Inc. in 2010. (See related: Which US Airlines Are Poised For Long-Term Gains?)
As the U.S and global economy slowly improve, there is likely to be a positive impact on demand for air travel. Both business and leisure travelers are likely to hike up their demand, boosting the revenues of airline companies. In fact, the trade association Airlines for America expects the summer 2015 season to see a 4.5 percent hike in U.S. passenger traffic to its highest-ever level.
And as airlines benefit from reduced fuel prices, they are more likely to reward shareholders through means such as share buybacks and hiked-up dividend payouts. Airline companies, including Delta, American Airlines Group and Southwest, have hiked up their share buyback programs to reward shareholders.
In addition, the price-to-earnings ratio of major airline stocks compares favorably to the more than 17 price-to-earnings for the S&P 500 overall, based on 2015 earnings estimates. In comparison, the price-to-earnings ratio for airline stocks ranges from 5 for American Airlines to 12 for JetBlue Airways Corporation (JBLU).
The Bottom Line
Airline stocks have a number of positive factors going for them even as their share prices have taken a hit. They are likely to see a major positive impact from oil price declines even as they enjoy the benefits of increased consolidation that has also cut down on competition in an improving economy. That’s why investors would do well to keep an eye on airline stocks. However, investors should also keep in mind risks such as addition of capacity and airfare wars that could cut into the profitability of airline companies. And the outcome of the government collusion investigation could also negatively impact these stocks. Also, those interested in the airline sector should investigate each company on its own merits.